Economic and Industry Analysis

1
Economic and Industry Analysis

• Timothy R. Mayes, Ph.D.
• FIN 3600 Chapter 11

2
Fundamental Analysis

• Fundamental analysts look for companies whose
  financial health is good and getting better, and
  which are undervalued by the market
• They scour financial reports, calculate ratios,
  compare to other similar companies, etc
• Fundamental analysts believe that earnings drive
  stock prices at least in the long run
• Fundamentalists tend to be buy and hold
  investors, as opposed to technicians who tend to
  be shorter-term traders

3
Top Down Analysis

• Traditionally, fundamental analysts perform a
  top down analysis to determine which stocks to
  buy or sell.
• The top down method consists of
• A macro economic analysis
• An industry analysis
• A company analysis
• In this chapter we will cover the first two.

4
Macro Economic Analysis

• There is a strong linkage between growth in the
  overall economy and growth in company earnings
  (which drive stock prices, at least in the long
  run).
• The following graph shows that changes in nominal
  GDP explain about 37 of the changes in corporate
  profits on average.
• Obviously, then, to know where earnings (and thus
  stock prices) are going, we need to know where
  GDP is going.
• A GDP forecast is our starting point. This
  forecast can be had from a number of sources
  including brokerage firm analysts, bank
  economists, and the WSJs semi-annual survey.

5
Earnings GDP
Data Source http//www.freelunch.com Data are
from Q1 1946 to Q2 2001
6
Example of Economic Forecast

• This forecast, from The Conference Board as of
  January 3, 2007 is an example of the freely
  available forecasts that can be obtained.

7
Example of Economic Forecast (cont.)
8
What Your Forecast Should Include

• Any macro economic forecast should include
  estimates of all of the important economic
  numbers, including
• Real GDP growth
• Inflation rates
• Interest rates
• Unemployment
• And probably others, depending on your needs.

9
Types of Forecasts

• There are two types of forecasts
• Quantitative based on econometric models.
• Qualitative based on educated guesses.
• Qualitative forecasting is less difficult, and
  probably as good as quantitative forecasting.
• Furthermore, we can blend the two methods.
• There is another technique known as a
  barometric forecast which is an average of the
  forecasts by many others.

10
Forecasting for the Layperson

• The most important thing to do is to watch for
  releases of various economic statistics by the
  government and private sources. These are widely
  reported by the financial media (WSJ, CNBC, etc).
• Especially, keep an eye out for the Index of
  Leading Economic Indicators, The Consumer
  Confidence Index, the Feds Beige Book, comments
  by the chairman of the Board of Governors of the
  Federal Reserve, unemployment rates, monthly
  inflation indices, etc.

11
Defining Recession and Depression

• An old saw is that a recession is when your
  neighbor loses his job, and a depression is when
  you lose yours.
• A better definition (but not exactly correct) is
  that a recession occurs when real GDP declines
  for two consecutive quarters.
• The NBER Business Cycling Dating Committee is the
  official arbiter of the timing of recessions.
  Its definition (from http//www.nber.org/cycles.ht
  ml) is
• The NBER does not define a recession in terms of
  two consecutive quarters of decline in real GNP.
  Rather, a recession is a period of significant
  decline in total output, income, employment, and
  trade, usually lasting from six months to a year,
  and marked by widespread contractions in many
  sectors of the economy.
• A growth recession is a recurring period of slow
  growth in total output, income, employment, and
  trade, usually lasting a year or more. A growth
  recession may encompass a recession, in which
  case the slowdown usually begins before the
  recession starts, but ends at about the same
  time. Slowdowns also may occur without recession,
  in which case the economy continues to grow, but
  at a pace significantly below its long-run
  growth.
• A depression is a recession that is major in both
  scale and duration.

12
Post WWII Recessions

• There have been 11 recessions in the U.S. economy
  since 1945. The latest began in March 2001
  (though many indicators began peaking long before
  that, especially in Q4 2000), and ended in
  November 2001.

13
Index of Leading Economic Indicators

• The LEI has 10 components, each with a specific
  weighting

14
Leading Indicators and the Economy
15
Index of Coincident Indicators

• The Coincident Indicators Index has 4 components,
  each with a specific weighting

16
Coincident Indicators and the Economy
17
Index of Lagging Indicators

• The Index of Lagging Indicators has 7 components,
  each with a specific weighting

18
Lagging Index and the Economy
19
Consumer Confidence

• The Consumer Confidence index is released
  monthly.
• It is a mail survey of 5,000 individuals with an
  average of 3,500 responses.
• In the survey, respondents are asked 5 questions
• Respondents appraisal of current business
  conditions.
• Respondents expectations regarding business
  conditions six months hence.
• Respondents appraisal of the current employment
  conditions.
• Respondents expectations regarding employment
  conditions six months hence.
• Respondents expectations regarding their total
  family income six months hence.
• There are three possible responses Positive,
  Neutral, Negative.

20
Consumer Confidence (cont.)

• The index has two components
• Expectations (most important)
• Present Situation
• The overall index is calculated as the average of
  the relative positive/negative responses to all 5
  questions.
• The expectations component is an average of the
  responses to questions 2, 4, 5.
• The present situation component is an average of
  the responses to questions 1 and 3.
• Before averaging, all responses are adjusted
  relative to their 1985 values.
• The responses to each question are also
  seasonally adjusted.
• Source http//www.consumerresearchcenter.org/cons
  umer_confidence/methodology.htm
• There is also a consumer sentiment index
  published by the University of Michigan.

21
Inflation Indicators

• There are many indicators of inflation in the
  economy. (Inflation is defined as a general
  increase in the level of prices.)
• The four most-watched indicators are
• The Consumer Price Index (CPI)
• The Producer Price Index (PPI)
• The GDP Deflator
• The Employment Cost Index (ECI)

22
Consumer Price Index

• The CPI is published monthly by the Bureau of
  Labor Statistics (http//www.bls.gov/cpi/).
• There are many versions (even one for
  Denver-Boulder-Greeley area which is published
  semiannually), but the most watched is the
  Consumer Price Index for All Urban Workers
  (CPI-U).
• The CPI measures the change in price of a market
  basket of goods typically purchased by
  consumers. The items in this basket are
  determined by periodic surveys of about 30,000
  consumers around the country.
• It is broken into two components
• The total CPI (often called the Headline
  Number)
• The Core CPI (ex food and energy which are quite
  volatile)
• Watch both numbers, but the core CPI is the best
  indicator.

23
Consumer Price Index (cont.)

• The expenditure items are from 200 categories
  arranged into 8 major groups
• FOOD AND BEVERAGES (breakfast cereal, milk,
  coffee, chicken, wine, full service meals and
  snacks)
• HOUSING (rent of primary residence, owners'
  equivalent rent, fuel oil, bedroom furniture)
• APPAREL (men's shirts and sweaters, women's
  dresses, jewelry)
• TRANSPORTATION (new vehicles, airline fares,
  gasoline, motor vehicle insurance)
• MEDICAL CARE (prescription drugs and medical
  supplies, physicians' services, eyeglasses and
  eye care, hospital services)
• RECREATION (televisions, cable television, pets
  and pet products, sports equipment, admissions)
• EDUCATION AND COMMUNICATION (college tuition,
  postage, telephone services, computer software
  and accessories)
• OTHER GOODS AND SERVICES (tobacco and smoking
  products, haircuts and other personal services,
  funeral expenses).

24
Producer Price Index

• Like the CPI, the PPI is published monthly by the
  Bureau of Labor Statistics (http//www.bls.gov/ppi
  /).
• The PPI measures changes in wholesale prices.
• There are over 10,000 versions of the PPI
  published every month for individual products and
  services.
• Investors watch the PPI, but mostly focus on the
  CPI.

25
GDP Deflator

• The GDP Deflator is published quarterly by the
  Bureau of Economic Analysis (http//www.bea.doc.go
  v/) in the GDP report.
• The GDP Deflator measures changes in the prices
  of all domestically produced products, and is the
  broadest of all inflation indicators.
• It includes many things (trains, planes, etc)
  that consumers do not buy as well as everything
  they do buy.
• This measure of inflation is less-watched than
  the CPI, but it can be important and it tends to
  be less volatile.

26
Employment Cost Index

• Like the CPI and PPI, the ECI is published by the
  Bureau of Labor Statistics (http//www.bls.gov/ncs
  /ect).
• The ECI measures changes in the cost of employee
  compensation (wages and benefits), and is
  published quarterly as part of the National
  Compensation Survey .
• The ECI is reported to be one of Alan Greenspans
  favorite inflation measures.

27
The Beige Book

• The Beige Book (http//www.federalreserve.gov/FOMC
  /BeigeBook/2001/default.htm) is a summary of
  current economic conditions around the country
  published by the Federal Reserve Board.
• The Beige Book is published 8 times per year and
  is based on anecdotal evidence gathered through
  interviews with bank directors, economists,
  business contacts, etc.
• It contains an overall summary, plus reports from
  each of the 12 districts (Colorado is in the 10th
  district, Kansas City).

28
Unemployment

• As part of its monthly Current Population Survey
  (http//www.bls.gov/cps/home.htm), the Bureau of
  Labor Statistics produces the Unemployment Rate.
• The unemployment rate is determined by a survey
  of individuals who are then placed into one of
  three categories
• Employed
• Unemployed and seeking work
• Unemployed and not seeking work (discouraged
  workers)
• The unemployment rate is the ratio of unemployed
  to the total number in the workforce (discouraged
  workers are not counted).
• Note that the labor force is actually the
  civilian labor force, it does not include those
  in the military.

29
Forecasting Is Hard

• Forecasting is difficult, especially if it
  concerns the future.
• That phrase has apparently been uttered by many
  famous people, and I cant track down the
  original. However, truer words have never been
  spoken.
• Economic forecasting is especially difficult, and
  the forecasts are wrong almost by definition.
• There are many reasons why this is the case
• Old or bad data
• Unexpected shocks (the Sept 11 tragedy is a
  perfect example)
• Using historical data which gives no clues about
  major structural changes about to occur
• Blindly following trends

30
Forecasting Is Hard (cont.)

• John Casti in his 1990 book Searching for
  Certainty What Scientists Can Know About the
  Future evaluated forecasters from many fields and
  gave economists a D. Stock market forecasters
  got a very generous C and physicists got an
  A.
• Probably the most notoriously wrong forecast of
  all time came in the early fall of 1929 when the
  great economist Irving Fisher said, "Stock prices
  have reached what looks like a permanently high
  plateau."
• So, you see, forecasting is hard and your efforts
  are nearly always wrong.
• The next slide shows an analysis of just how
  accurate a group of professional economists
  were at predicting various indicators about 6
  months ahead in 2004.

31
Forecasting Is Hard (cont.)
32
Forecasting Is Hard (cont.)
33
Why Forecast Economic Aggregates?

• We dont have a choice. We are making decisions
  whose outcomes depend on the future, and we must
  make these decisions using the best available
  information that we have.
• Otherwise, all decisions may as well be made by a
  coin toss (and even bad forecasts are usually
  better than that).
• It is probably best not to pay too much attention
  to the point estimates of the forecast, instead
  look for trends (is GDP expected to grow slower,
  faster, or about the same?).
• It is also important to constantly be on the
  lookout for solid reasons to revise your
  forecast, and change your decision.
• Its no sin to be wrong, but failing to admit it
  and adjust is.

34
Industry Analysis

• Once we have done a thorough economic analysis,
  we ask the question which industries will
  benefit most from the upcoming economic
  environment?
• This will lead to several industries, and our
  analysis will lead us to choose the one that we
  find to be best positioned.

35
What is an Industry?

• An industry is a group of companies which produce
  similar goods and/or services.
• Until recently (and often still), industries were
  classified by Standardized Industrial
  Classification (SIC) codes, but this was replaced
  by the North American Industry Classification
  System (NAICS, http//www.census.gov/epcd/www/naic
  s.html) which is much more detailed than SIC.
• SIC codes were 4-digit, while the NAICS uses 6
  digits for a much finer, and more useful,
  breakdown of industries.
• NAICS will also facilitate comparisons of
  companies in the US, Canada, and Mexico (it was
  developed by all three countries for this
  purpose).

36
Components of Industry Analysis

• The purpose of industry analysis is to identify
  which industries will be good for investors in
  the upcoming environment.
• Your textbook has an excellent discussion of 9
  issues that should be addressed
• Competitive Structure
• Permanence
• Phase of Life Cycle
• Vulnerability to External Shocks
• Regulatory and Tax Conditions
• Labor Conditions
• Historical Financial Performance
• Financial and Financing Issues
• Industry Stock Price Valuation

37
Competitive Structure

• Some of the questions to be answered are
• What companies are in the industry?
• What are their market shares?
• Which are publicly traded?
• Has the number of competitors been rising,
  fallen, or remained stable?

38
Permanence

• Some of the questions to be answered are
• Is the industry likely to survive in the
  long-run?
• Are there any major technological threats (such
  as laser printer was to the dot matrix printer)?
• Are there regulatory threats?

39
Phase of Life Cycle

• Some of the questions to be answered are
• Where is the industry in its life cycle? The
  best returns and most risk tend to occur early in
  the cycle.
• The possible phases are
• Birth Phase
• Growth Phase
• Mature Growth Phase
• Stabilization or Decline Phase

40
Vulnerability to External Shocks

• Some of the questions to be answered are
• Could major portions of the industry be
  nationalized by foreign governments?
• Are they dependent on supplies of key commodities
  (such as oil)?
• Are they subject to external political whims?
  (South Africas gold industry suffered when
  Apartheid became an international issue.)
• Are they subject to fashion trends that may soon
  change?

41
Regulatory and Tax Conditions

• Some of the questions to be answered are
• What are the current regulations that the
  industry faces?
• Are there likely to be new regulations?
• Are the industrys products subject to special
  taxes (such as sin taxes on alcohol and tobacco
  products or the windfall profits tax on oil
  companies in the 1970s)?
• Are there special tax breaks offered to the
  industry?

42
Labor Conditions

• Some of the questions to be answered are
• What percentage of the industrys workers are
  unionized?
• Are the unions generally hostile or complacent?
• Is unionization increasing or decreasing?
• Are qualified workers easily obtainable, or are
  they difficult to find? This has been a
  particular problem for the high-tech industries.

43
Historical Financial Performance

• Some of the questions to be answered are
• What is the historical record of industry
  revenue, earnings and dividends?
• Are these financial variables cyclical,
  counter-cyclical?
• Have they been growing slowly, rapidly, or about
  average?
• What is the average cost structure in the
  industry? Heavy on fixed costs? Or, are
  variable costs the lions share?

44
Financial and Financing Issues

• Some of the questions to be answered are
• How much debt does the average firm have?
• What is the mix between fixed assets and current
  assets? Is it labor intensive or capital
  intensive?
• What is the average age of the fixed assets?
  Will they have to be replaced soon?

45
Industry Stock Price Valuation

• Some of the questions to be answered are
• What is the historical average P/E for the
  industry?
• How high has it been? What were the economic
  conditions when the highs were hit?
• How low has it been? What were the economic
  conditions when the lows were hit?
• Where is it now? Where should it be, based on
  historical economic comparisons?
• What kinds of capital gains and dividend yields
  have historically been generated?

46
Sources of Industry Information

• The primary sources of industry-wide information
  are trade groups, for example
• Semiconductor Industry Association
  (http//www.semichips.org/)
• Wards (automobiles, http//www.wardsauto.com/)
• Electronics Industry Association
  (http//www.eia.org/)
• Software Publishers Association
  (http//www.spa.org/)
• There are also many trade magazines that may, or
  may not, be published by the trade associations.
• Additionally, Value Line Investment Survey
  (http//www.valueline.com/) publishes an analysis
  of each of the industries that they cover.
• Finally, research analysts at brokerage firms
  often provide reports on the industries that they
  cover.